What is an ETF
What is an ETF?
An Exchange Traded Fund (ETF) is a security designed to track the performance of a specific underlying asset. For example, an ETF can be used to track the performance of a particular market, industry sector, trading strategy, or other types of investments. Although this sounds complicated, a simple way to think about it is like a high school report card. The report card can track a student’s performance in various courses, summarizing a combination of assignments, tests, exams, and projects into one finalized grade for a subject. Just because an individual did poorly on one test doesn’t mean the final mark will decrease substantially. An ETF does something similar, but instead of measuring performance in a class, it can measure the performance across various factors for investing. ETFs are called Exchange Traded Funds because they are traded on stock exchanges like the Toronto Stock Exchange. An ETF can be purchased on an exchange any time the market is open, just as you would buy a share of Amazon.
Essentially, an ETF is a collection of securities like stocks or bonds that have been bundled together to make up one asset. Another way to think of an ETF is as a picnic basket. Typically, a picnic basket may hold cheese, apples, drinks, and other types of food. However, for an ETF, these foods and beverages can be replaced by individual stocks, and the ETF is the basket that holds them. For example, an ETF that tracks technology stocks may include Apple, Microsoft, Facebook, and Google. However, instead of purchasing individual shares in Apple or Microsoft, you would buy a share of the ETF. As a result, by purchasing the ETF, you would be purchasing small quantities of Apple, Microsoft, Facebook, and Google at the same time.
Advantages of ETFs
Diversification: A significant advantage of ETFs is that they provide immediate diversification. Diversification simply means that capital is allocated to a variety of different assets rather than just one. In this context, diversification allows you to invest in more than one single opportunity, which decreases the impact of a single investment failing. In other words, you are not putting all your eggs in one basket.
Diversification reduces the risk of your portfolio’s value decreasing from a single event. Individual stocks or assets declining in value affect the ETF less than a portfolio directly invested in those stocks or assets. For example, if all your money is invested in Tesla, and Tesla shares decrease in value, then you will have lost money. However, if your money is split between Tesla and Amazon, and Tesla decreases in value while Amazon increases, you may not lose any. Either way, in that scenario, because Tesla and Amazon are different companies operating in a similar space (Technology), an ETF tracking both companies will be less affected by one of the companies reducing in value.
As discussed earlier, an ETF is essentially a basket. Therefore, you gain immediate diversification when you purchase an ETF because your investment is spread between multiple assets. In the context of the picnic basket example, if one of the foods at a picnic spoils and becomes inedible, it won’t ruin the picnic because there were multiple types of food in the basket.
Low Cost: ETFs are often a less expensive option than other types of funds. ETFs are known as “passively managed funds.” Passive management means once the initial assets are chosen, they generally stay the same. For example, a technology ETF focusing on fortune 500 tech companies will rarely change its holdings (the stocks within the ETF remain the same). On the other hand, other popular funds such as mutual funds are actively managed. An active strategy means that the assets within the fund are constantly changing. The fund managers are actively buying and selling stocks based on market conditions.
Compared to actively managed funds, passive funds like ETFs generally have a lower expense ratio. The expense ratio measures how much of the fund’s assets are used to pay for administrative and operating expenses. As ETFs are passively managed, their expenses are low because they do not have to pay for marketing, portfolio managers, or constant transaction fees from buying and selling stocks. Transaction fees are associated costs to trade physical stock.
Easy to Trade: Another advantage of ETFs is that they trade just like stocks on regular stock exchanges. An ETF can be purchased at any point during regular trading hours and is therefore easy to buy or sell when you need your money back. Other investments may only have a small window when they can be traded (e.g., Mutual Funds) or a specific period in which you cannot take your money out (e.g., GICs). These other types of investments will be discussed in later articles.
Disadvantages of ETFs
Ignores Current Market Conditions: While the passive approach of ETFs often reduces their cost, it also prevents the fund from reacting to market conditions. For example, suppose you purchase an ETF that tracks Google, Facebook, Apple, and Microsoft. If the ETF is heavily weighted towards Google, and Google is not performing well, then the value of the ETF will decrease. If this was an active fund, management would sell the shares of Google and purchase shares of other better-performing stocks.